Money Matters | Human Resource Executive Online
Realizing the savings promised by HR outsourcing can prove trickier than initially thought. Two experts share their advice for getting the most from your HRO provider.

By Barbara Melby and Vito Petretti

Monday, March 16, 2009

Many companies have evaluated or are evaluating outsourcing as a strategy to enable overall savings in their cost of delivery of HR services. While there are many drivers behind a company's decision to outsource -- including access to new systems and better processes, and more flexible pricing models -- one of the key motivators to outsourcing has almost always been the requirement for savings.

In light of today's tough economic climate, when the revenues of many companies are decreasing and human resource departments are being required to make significant budget cuts, the potential for cost savings plays an even more important role in a company's decision to outsource any or all of its HR functions.

During the pre-contract evaluation and contracting process, bold savings forecasts are often made. These forecasts are often determining factors in the decision to outsource or which service provider to select. However, a common grievance is that the actual savings tend to fall short of what was projected.

So the natural question is, how can customers ensure that they realize the projected savings forecasts? These forecasts are often what is conveyed to senior management and, when missed, can cause problems for the outsourcing advocates.

Transparency and Risk

Outsourcing customers typically look to their service providers to reduce the overall cost of providing HR services through the implementation of more efficient processes and systems, the use of leveraged service models and, in many cases, the move to lower-cost geographies for providing basic services. It's incumbent upon any outsourcing customer to truly understand the provider's delivery and staffing model and the pricing structure it plans to use.

For example, if the service provider proposes a delivery model that cannot support the pricing model being proposed, then a natural assumption would be that there are hidden costs and expenses that will be passed onto the customer after the contract is signed.

Many outsourcing customers seek to simplify their pricing structures and implement pricing based on their employee headcount or a transaction-based model. While these models can be very attractive if constructed well, the customer needs to understand what is included in the fees, how additional or lesser volume is handled and what constitutes additional or new services.

The more transparency that the customer can get into the provider's pricing model and fees, the more likely it will get a pricing model that reflects actual fees. That, in turn, will help the customer more accurately forecast the anticipated savings from outsourcing.

In order to ensure savings, the customer needs to anticipate and understand hidden financial risk. Customers often fail to adequately account for financial risk in areas such as inflation risk, currency risk, tax exposure, responsibility for expenses (especially travel) and due-diligence errors and omissions:

* Inflation. A common risk area that customers do not adequately account for in pricing models is the impact of inflation. Outsourcing customers should be clear in their contract how inflation (and deflation) is handled, including when fees are adjusted for inflation, which indices should apply, whether U.S. indices are appropriate or whether local geography indices should be used, which percentage of the fees are inflation-sensitive and whether the customer's inflation should be capped.

* Currency Risk. With offshoring becoming part of most outsourcing models, service providers are looking to pass all or some of the currency risk onto their customers. Customers need to consider which currency fees will be billed in and how currency-risk exposure will be allocated.

* Taxes. Many jurisdictions impose or are contemplating imposing services taxes. If the customer currently provides a function in-house, then it may not realize that using a third party to provide a service may expose it to taxes on all or some of the fees. The taxes vary by jurisdiction and may change over the term of the contract.

* Expenses. One area that is often forgotten when building pricing models is how certain ancillary expenses, such as travel, will be handled. The outsourcing customer not only has to consider the service provider's travel (which may include international travel), but the travel of its own retained personnel as well.

* Due Diligence. Errors or omissions in due diligence often result in an adjustment in pricing that customers do not anticipate. If time allows, customers should spend a reasonable period of time collecting a contract's volume and base-case information to ensure that it is accurate. One way for customers to limit post-contract adjustments is to expressly forbid such adjustments in the contract or limit the period of time that such adjustments can be made.

One of the most effective mechanisms for ensuring that projected savings are realized is a "guaranteed" savings clause. However, not all service providers will sign on to such a clause because (a), the service provider cannot validate the customer's base financial case and (b), projected savings are only as good as the customer's ability to understand and document its current spend (which many customers cannot do).

Yet another reason service providers will not guarantee savings is that they can't predict or take the risk of changes within the customer's business environment.

If the service provider will commit to guaranteed savings, then the devil is often in the details. What are savings based on, how will savings be calculated and what happens if savings are not achieved?

Another spin on a guaranteed savings provision is a gain-sharing provision that's intended to "incent" the service provider to obtain certain savings. If the service provider helps the customer obtain a certain level of savings, then it receives a bonus based on a percentage of the savings.

It should be noted that many service providers don't embrace guaranteed savings or gain-sharing provisions on the basis that key drivers in determining savings are not within its control. From the service-provider's perspective, it contracts with the customer to provide certain services at a certain fee, and it is up to the customer to determine if that fee will generate the desired level of savings.

The following are some additional processes and contractual agreements an outsourcing client should consider:

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* Benchmarking. While benchmarking will not, by itself, guarantee savings, it is a tool that can be used by the customer to verify that it's receiving competitive rates. In order to be effective, a benchmarking provision would ideally require an automatic pricing adjustment if a service provider's pricing is revealed to be out of line with some segment of the benchmarked population of service providers.

If the service provider isn't willing to agree to an automatic adjustment (and not many will be), at the very least, an effective benchmarking provision would require the provider to renegotiate the fees. In such cases, the customer should also negotiate the right to terminate the contract with no termination fees if the parties cannot reach an agreement on the adjusted fees as part of the mandated renegotiation provision.

Most well-drafted contracts will also include a requirement that the service provider make continuous efforts to improve the efficiency of the services or use new or improved technological advances in the delivery of the services.

The contract may include both a general obligation to this effect and a provision requiring the service provider to present some minimum number of recommendations per year. Generally, a service provider would be required to present these ideas during governance meetings or annual reviews.

The customer may choose to offer the service provider the further incentive of sharing in a portion of the savings resulting from any cost-saving proposals offered by the service provider.

* Competitive Pricing. Probably the best way to ensure competitive pricing and thereby increase the chances of ensuring cost savings is to include a provision that states the relationship between the customer and service provider is nonexclusive and that the customer has the right to use third parties to perform portions of the outsourced services.

While this provision allows a customer to competitively bid a portion of the services, exercising the right to allow a third party to provide the services may not be practical depending on whether it is possible to easily segregate portions of the outsourced services. Another mechanism for enabling nonexclusivity is a termination for convenience right.

* Cost-Efficient Services. A customer may also include a provision in its outsourcing agreement that requires a service provider to perform the services in a cost-efficient manner. Such a provision would contractually obligate the service provider to make efficient use of resources (both service provider and customer resources) through a variety of methods, such as tuning or optimizing the computer systems used to perform the services or controlling its use of the customer's network by scheduling usage, where possible, to low-utilization periods.

* Service Levels. Depending upon the service-delivery and pricing model, it may be possible to include quantifiable service levels (e.g., for project work, on-time and on-budget delivery of the services are common service levels). These service levels may have penalties (or service credits) associated with them if missed, as well as a possible termination right.

While guaranteeing savings is a tough proposition for both the outsourcing customer and the outsourcing service provider, savings projections are achievable. In these challenging economic times, it is imperative to put contractual provisions in place that limit hidden costs and unanticipated financial risk. The best advice for any client is to understand its business case, demand transparency and require competitive, firm pricing that is as inclusive as possible.

Barbara Melby is a partner in the global outsourcing practice at Morgan Lewis and Bockius in Philadelphia. Vito Petretti is an associate in the firm?s global outsourcing practice.